Multinational entities are able to optimise their profitability by restructuring functions, assets and risks. These are business restructurings in which specialisation and rationalisation are aimed at making operations more efficient. In this way, an attempt is made to achieve the economies of scale and synergy envisaged in mergers and acquisitions.
Restructuring often involves the relocation of activities to other countries. Many tax authorities are critical of such restructuring operations because they see that this can be to the detriment of their own treasury. This is often a reason for taking active steps against them. The question is often whether, and to what extent, such restructurings should result in an exit tax in the country where the functions disappear, and whether some restructurings as such should not be ignored, if it is suspected that tax considerations are the main driver of a business restructuring.
The OECD defines business restructurings as the cross-border reorganisation of commercial or financial relations between associated enterprises, including the termination or substantial renegotiation of existing arrangements.
The main types of business restructurings that are distinguished are:
- Change from full-fledged distributors to limited risk distributors or commissioner, whereby a (foreign) associated enterprise will operate as a principal;
- Change from full-fledged manufacturers to contract manufacturers or toll manufacturers whereby a (foreign) associated enterprise acts as a principal;
- Transfers of intangible assets to a central entity (the so-called IP company) within the group;
- Concentration of functions in a regional unit with a concomitant reduction in locally performed functions.
The arm’s-length compensation for business restructurings and transfer pricing
The discussion of business restructurings occurs in practice mainly when restructuring takes place within the group. Restructuring may relate to the circumstance that something of value is transferred. But it may also relate to situations in which the conditions under which certain activities are carried out change, or that the activities are completely stopped (think of the closure of a factory).
In assessing the arm’s-length nature of the restructuring, it will be necessary to consider how unrelated parties would have acted in such situation. It is therefore important to consider the following:
- The functions, assets and risks before and after the business restructuring;
- The economic reasons for the restructuring and the expected benefits for the various parties;
- The possible alternative options for the parties involved;
- The accurate delineation of the transactions in relation to the business restructuring.
As with any transaction, the business restructuring analysis should assess what exactly is happening in the economic and financial relationships of the parties involved in the transaction. Again, the contract, the actual behaviour, the management of the risks (before and after the restructuring) and the financial capacity to bear those risks need to be studied carefully. Understanding the business restructuring is necessary before one can even make an arm’s-length judgment. Without understanding how functions, assets and risks are distributed before and after the business restructuring it seems impossible to say anything about the restructuring as such and its arm’s-length nature.
For the evaluation of the arm’s-length nature of the restructuring, it is very helpful if the so-called business rationale of the restructuring is clearly mapped out, with attention to the economic significance for the various individual parties. The perspective of all related parties involved should be clear.
A lack of understanding of the economic reasons for the restructuring will quickly give the tax authorities the impression that the transaction was undertaken only for tax reasons. Practice shows, however, that other reasons often form the basis for the restructuring. For example, the more efficient organisation of the business or the achievement of possible synergy benefits. It goes without saying that documentation on these reasons has to be present in the group.
The understanding of the economic reasons for the restructuring will also provide more clarity on the allocation of risks between the parties. It will be clear that an analysis of the allocation of risks before and after the restructuring is important. After all, bearing risks has consequences for the expected remuneration in relation to the activities carried out and for the possible consequences if the risks are actually manifested. If, as a result of a business restructuring, significant risks are transferred from one party to another, this can have major consequences for the transfer pricing and the actual profit (or loss) to be realised. Within each business restructuring, therefore, two questions must always be asked:
- Is risk transfer appropriate in view of control and financial capacity?
- Did the transfer price and the prices after the business restructuring take proper account of the risks?
If the changes in a business restructuring are not accompanied by a change in the management of the risks that are important for the company concerned, critical attention is required. In chapter 9 of the Transfer Pricing Guidelines attention is paid to the allocation of risks, because a large proportion of the identified restructurings involve a shift of risks to other companies. And because a changed risk profile also has direct consequences for the expected remuneration and the possible costs (as a result of being at risk), such a change has a direct impact on transfer prices. The change of a certain risk allocation is particularly prominent in business restructurings. The question here is under what conditions this reallocation can take place.
In the case of business restructuring, the company will usually be able to show what purpose and benefit is intended. From an economic perspective, there will be a benefit from changing the economic model used. An economic benefit for the group as a whole does not necessarily mean an economic benefit for all individual parties. If a restructuring is commercially rational for the group as a whole, it can be expected that an arm’s-length reward will be available to each of the participants in the restructuring for the remaining activities and a compensation for the restructuring itself. Indeed, an unrelated party will only change its activities if the options realistically available are not more favourable to it. The analysis of the options realistically available is necessary to assess whether an unrelated party would enter into such a transaction on the agreed terms.
If, in the context of a restructuring, only the allocation of risks is adjusted without any change in the functions and the assets used, it is likely that the tax inspector will have to be critical as to whether such a reallocation of risks can be considered as arm’s length.
Recognition of the transaction
There has been frequent discussion about the possibilities of reclassifying or ignoring certain transactions for tax purposes on the basis of the arm’s-length principle. In the case of business restructurings, too, the question has arisen as to whether the transactions identified can be recognised as rational transactions.
According to the OECD guidelines, the contractual terms of the transactions actually carried out remain the starting point for any analysis. Only in exceptional situations will it be possible to ignore the transaction. This can only happen if the business restructuring as a whole can be classified as economically irrational, making it impossible to set a price that will be acceptable to both parties.
In general, commercial irrationality in business restructurings occurs when the transaction does not add value to the group’s aggregate profits. If the transaction does add value to the aggregate profit of the group, the transaction is commercially rational. The fact that the restructuring is commercially rational for the group as a whole does not mean that it is rational for all the individual parties. However, if the restructuring is rational for the group as a whole, then adjusting the transfer price or some other form of compensation can generally make the transaction rational for all parties without ignoring the transaction as such. In other words, if the overall benefits outweigh the disadvantages, there is always a possibility to adequately compensate the disadvantaged party by adjusting the terms of the transaction.
The Transfer Pricing Guidelines recognise that obtaining a tax benefit should not in itself lead to ignoring the transaction. But the tax saving must be realised with transactions based on arm’s-length terms. If a function is actually transferred to a country with a lower tax rate in order to realise a cost advantage, this transfer cannot be ignored as a transaction.
The consequences of ignoring transactions cannot go as far as denying or ignoring the functional changes that have actually occurred within the group organisation.
In short, during business restructurings it is important to have a clear understanding of the reasons for the restructuring for all parties involved. These may be economic reasons, but also, for example, to organise business operations more efficiently or to achieve possible synergy benefits. It is necessary to understand the current structure of the group, to come up with a new structure that is in line with the goals set and also matches with how the group operates, and to identify the problems that the restructuring might bring.
Since business restructurings usually take place within the group, intercompany agreements are also important to make the business restructuring possible. See here for a more detailed explanation of intercompany agreements.
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T. van Egdom, Verrekenprijzen